After a tumultuous 2022, where we saw the worst bond market in over a century and the worst equity market in 14 years, many investors were happy to be hitting the reset button. Although the New Year was supposed to be a fresh start, investors were still digesting a rough December market that had sentiment at exceptionally negative levels. Media headlines such as “Will there be a hard landing or soft landing”, “Yield curve inversion at a record”, “Fed continues to embark on the fastest rate hiking cycle in history”, “Earnings too high” were dominating news flow so the sustained negative mood was understandable. In the first four months of the year, we have seen a lot of these “fears” come to fruition, but a funny thing happened; the market didn’t implode like many had predicted. It actually went…up!.
Despite the market appreciation, we are still seeing a lot of discussion about the same fears we had at the beginning of the year because they have continued to be relevant. So, what gives? Is there nothing to fear? Why are banks failing and the market is continuing upwards? How does a 17X price to earnings multiple make sense when we continue to have higher inflation? Maybe the answer to the lesson is a constant, the financial markets are a discounting mechanism and look out anywhere from 9-12 months. As a result, it appears as though the market is looking through a lot of the current stresses in the system. With that in mind, let’s take a deeper look at some of the major topics/events from the first four months of the year and try to make sense of it all.
1. Financial Contagion
Life comes at you fast and the regional banking story from March and April is a prime example of that. While at last count we had seen five smaller banks fail, the poster child for the story was Silicon Valley Bank which had heavy exposure to new tech firms in California. Once hailed as a market darling, SVB bank had experienced a period of unprecedented growth in the years leading up to its collapse. The bank had thrived on its reputation for innovation and risk taking while situated perfectly in Silicon Valley to take advantage of the Covid tech boom. SVB was THE bank to deal with if you were a startup tech business. As the pandemic wore on and interest rates hit all-time lows, tech businesses in Silicon Valley were able to capitalize on raising capital. As the tech start-ups continued to raise capital, SVB took advantage by gaining deposits and growing their loan book aggressively. From the 1st quarter of 2020 to the 1st quarter of 2022 SVB saw their deposits grow 220%. Compare that to 26% deposit growth seen at all FDIC-insured institutions over the same time frame.
Banks are in the business of maximizing their Net Interest Margin(NIM). To be profitable, the banks must do something about their deposits. Typically, a bank would lever up and loan out money at a higher interest rate to capture a spread between the deposit rate and the lending rate. Perhaps feeling as if the startup tech sector was in a bit of a bubble SVB was not overly aggressive on writing loans. The loan book at the time of the collapse was largely not in arrears. SVB’s strategy for how to handle the inflow of deposits was to create a “held-to-maturity” (HTM) portfolio which was a collection of longer-term government bonds. While no typical credit risk in that portfolio, they were loaded up in duration risk; a risk that investors prior to 2022 hadn’t really had to worry about in 40 years. Over the tech boom SVB grew their HTM portfolio from $14 billion at the end of 2019 to $91 billion at the end of 2022.
The tech boom seemingly ended in January of 2022 when the Federal Reserve started its historic interest rate hiking campaign. This new market environment that the economy shifted into would result in two things that would ultimately lead to the unraveling of SVB. First, due to the tighter economic conditions, SVB’s prized tech-based clients saw their funding dry up in Q4 2021.
US Venture-backed funding peaked at $94 billion and subsequently declined 62% to $36 billion by Q4 2022. This tighter environment not only saw SVB’s new inflows dry up, but they also began to see deposit outflows as their tech clients turned to burning cash to survive. SVB saw their deposits fall by 13% in 2022. Second, due to the FED’s increase in interest rates, SVB was beginning to experience deposit outflows and saw their HTM portfolio lose value (as interest rates go up bond prices come down) and by March of 2023 this portfolio had a $15 billion paper loss associated with it.
Subsequently, SVB tried to stop the bleeding of deposits by offering higher deposit rates than their competitors (1.17% vs 0.65%) however this did little to stop the outflows. The bank turned to the whole-sale funding markets to fund their short-term cash needs which began to put pressure on their NIM. As the situation continued to evolve, SVB eventually only had 6.5% of their assets in cash/reserves vs. 56% of their assets in investment securities. The liquidity of the bank continued to deteriorate and eventually SVB had to liquidate investment securities resulting in a realized $1.8 billion dollar loss. As they were trying to reinvest the proceeds into short-term treasuries at higher rates, SVB also went to the public markets looking to raise $2.25 billion to fund their liquidity issues. Considering at the time SVB’s market capitalization was $15.86 billion, the cash raise should have been handled with relative ease by the market. Upon the announcement of the restructuring, depositors became worried that the bank would not be able to meet redemptions and rapidly began pulling their deposits at an even faster pace. The speed was unprecedented and the urgency even more so. The biggest reason for the urgency was that of the $152 billion SVB had in deposits, 87% were uninsured (above the FDIC’s $250,000 threshold). Uninsured deposits at other major banks are usually around 47-48%, in comparison. Two days after the attempted cash raise, the California Department of Financial Protection and Innovation closed SVB and appointed the FDIC as receiver. Since those events, multiple banks have also failed. The largest one and main competitor of SVB, First Republic, which had a similar clientele with a large portion of their depositors’ assets above the FDIC insurance threshold.
Source: SVB price chart-Bloomberg as at Mar 31, 2023
So, what can be learnt from this debacle and what does it mean for the broader equity market and economy going forward? While probably too early to completely answer the question, it does appear that the problems have been contained to a few specific institutions where the banks’ risk managers misunderstood duration risk. Most bank failures are due to loan books that see degradation of credit quality throughout the cycle, i.e. default risk. This year’s initial bank failure was the opposite. The loan book was completely fine, but it was how the bank managed its duration risk which really became the culprit. 2022 was a lesson to risk managers and the importance of evaluating how they view interest rate or duration risk. Compliance officers and bond investors across the globe also need to partake in this activity.
2. Sticky Inflation
While not dominating headlines like in 2022, we still do have higher inflation than what we would consider normal. The most recent Consumer Price Index (CPI) headline saw April’s inflation on a year over year basis at 4.9%. Although higher than the 2% targeted number by the central banks, it is down significantly from the peak in June of 2022 at 9.1%. Improvement is there and the direction in which inflation is trending is positive. That being said, it has been elevated for multiple years now. So why hasn’t there been the economic collapse suggested by negative sentiment? The lesson here can be summed up with answering; what do financial markets do? A lot of investors get caught up in good vs bad. In other words, is the inflation environment right now good or is it bad? One needs to remember that better vs worse is what’s important to markets. A better question to ask about inflation would be, is the situation improving or is it worsening? We’ve been on the page since last summer that we had seen peak inflation and that the picture did look to be improving. It appears that we were correct on that call and that the improvement is continuing to happen.
Source: CPI Chart-Bloomberg
3. Inverted Yield Curve
Regardless of how you measure it the entire yield curve is currently inverted. What that means is that on an interest rate point you get no added value for extending term on your bonds. You may have noticed it with mortgage rates over the last 9 months but the shorter the term currently is, the higher the rate. Like anything, the efficacy of what the yield curve is telling you is up for debate. Some market participants will argue that this is a signal of an upcoming recession. Historically speaking this was true. If you look back at the 20th century, nearly all the recessions experienced were preceded by an inverted yield curve. In particular, where the 10-year rate went lower than the 2-year rate. Currently, the curve is the most inverted it’s been in over 40 years, which has many market participants screaming that the end is near. We’re nearly a year into things however, and the market has appreciated since the curve inverted. Now this can change at any time, but up until now the market has largely dismissed the inversion. So, what’s changed historically and why is this signal possibly no longer a sign? Our view is that while it is not a positive development, it likely means that the central bank is acting too restrictive for the current environment. It is not necessarily signaling that a recession is imminent, but that something in the system could break -the 5 banks failing may be just that. The biggest change on what the yield curve is signaling in our view happened in 2003. At that time, the Federal Reserve began to give guidance on what future plans/path of the federal funds rate would be. As a result, the 2-year rate went from being determined in a free market to essentially a tool that was simply pricing in what the market thought the federal fund rate would be in two years. It is this change that essentially lowered the efficacy of the effectiveness in selling equities due to a pending recession when the yield curve inverted.
Source: Inverted Yield Curve-Bloomberg
4. S&P500 Earnings
The final topic that the bears were warning about heading into 2023 was earnings, and that they were about to fall off a cliff. There are reasons why some were on this page and most of them revolved around a weakening consumer and high inflation. Although the bears largely were right on the direction of expected earnings for the 2023 calendar year, earnings expectations have decreased 3% so far during 2023 and 7% from the peak. What is less known, and historically speaking, is that earnings estimates are usually late and they typically bottom out 4-6 months after we see the market bottom. You can see that on the table below with recent EPS contractions.
Earnings Bottom vs Market Bottom
Months Earnings Bottomed after Market
Over the last 25 years the only earnings contraction that bottomed before the market bottomed was during the 2001-2002 bear market.
Source: SPX vs Earnings-Bloomberg
What’s been driving the positive movement then?
It could be a number of things. Despite some negative market appeal, our view is that the economic picture is improving, getting better not worse. Inflation, albeit sticky, is moving in the right direction and it appears as if growth has slowed down so much it’s going to have a tough time slowing down even more. As we reviewed things in Q1, we currently are in a period of “low-growth and low-inflation” on a rate of change basis. Below is our market cycle clock. Our current status is yellow (or cautious) which is indicative of a two steps forward one step back environment where absolute returns are generally positive. We’ve been in the environment since October and that is the exact market environment we’ve experienced.
Source: CPWM Market Cycle-Internal
The other thing that we don’t think is widely understood is the impact of the built-up savings, even if we are/do experience a recession. Currently the US consumer is sitting on nearly $2 Trillion of savings built up since the pandemic began which has never happened going into a recession and therefore an encouraging statistic. While total debt outstanding is back to pre-pandemic trend, the debt servicing level is near cycle lows.
Source: Household debt service ratio-JP Morgan Guide to the Markets Q2 2023 https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/
What’s the lesson then?
Financial markets are tricky and very rarely does a pronounced opinion of “all-in” or “all-out” pay off. The simple way to describe it is you’re never as right as you think you will be and the other side will never be as wrong as you think they will be. At times you can have the narrative right but the positioning wrong. For a lot of investors the first 4 months of 2023 have been a reminder of this constant lesson and a perfect example of how you need to keep an open mind with your market position/calls.
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